Coca-Cola's Q4 Earnings Disappoint but Provide No Reason to Panic

Coca-Cola (NYSE: KO  ) disappointed investors when it released fourth-quarter results Tuesday morning. The company announced 1% volume growth in the quarter, much worse than analysts' 3% estimate. This brought volume growth to 2% for the year -- better than PepsiCo's 1%  beverage volume growth but worse than Coca-Cola's 4% volume growth in 2012. Coca-Cola and PepsiCo each recorded 1% beverage volume growth in the fourth quarter; it was disappointing that Coca-Cola did only as well as PepsiCo, which has struggled to retain its share in the beverage market.

To put the report in perspective, Citi analyst Wendy Nicholson noted that when Coca-Cola announced 1% volume growth in the second quarter of 2013, everyone was shocked; it was the slowest volume growth for the company in years. A recurrence of mere 1% global volume growth may not be as shocking this time around, but it is no less concerning.

Where the problems lie
Coca-Cola is growing in many parts of the world. The only problem is that its two biggest markets, the U.S. and Europe, are struggling like they never have before. Combined, Europe and North America are responsible for 45% of Coca-Cola's segment operating profit. Unfortunately, both are difficult markets for the company.

Europe's case volume declined 1% in 2013, revenue increased 4%, and currency-adjusted operating profit declined 1%. Management blames the poor showing on weak economic conditions, particularly in southern Europe.

In North America, case volume declined 1% in the quarter, revenue remained flat, and currency-adjusted operating profit declined a whopping 12%. For the full year, currency-adjusted operating income declined a more modest 3%, while revenue was flat and case volume declined 1%. Management noted that the company gained market share in many of its categories, but the challenging operating environment made it all but impossible to grow operating profit.

PepsiCo's similar results provide further evidence that the challenges are industrywide and not relegated to Coca-Cola alone. Moreover, Coca-Cola has done relatively better than its peers. However, volume declines in the U.S. and Europe will likely continue in the coming years amid uncertain economic conditions and consumer health-awareness trends in developed countries.

Nevertheless, Coca-Cola announced plans to ramp up advertising spending. It plans to cut $1 billion in costs by 2016 and funnel that money into a renewed advertising campaign in an attempt to boost volume growth.

What it means for investors
Coca-Cola is also planning to return up to $3 billion to shareholders via share repurchases, in addition to the more than $5 billion to be paid out in dividends. The more than $8 billion that will be returned to shareholders in 2014 is equal to all of Coca-Cola's free cash flow in 2013. Management's willingness to return 100% of free cash flow to shareholders is a sign of the dearth of reinvestment opportunities and the uncertainty of Coca-Cola's future in the developed world.

To salvage its hold on the U.S., Coca-Cola is investing in healthy product lines, such as Zico Coconut Water, vitaminwater, and Honest Tea. However, 60% of Coca-Cola's U.S. revenue still comes from soft drinks. As a result, its North American volume will continue to stagnate until a recovery in employment ensues.

Coca-Cola's prospects are much better in emerging and developing markets, where a rising middle class and a strong appreciation for Western brands are driving volume growth. During 2012, case volume grew 7% in Eurasia and Africa, 1% in Latin America, and 3% in the Pacific. Together, these segments represent 55% of Coca-Cola's segment operating profit. The strength of these markets is masked by the company's poor performance in North America and Europe, but it represents an important source of shareholder value going forward.

Bottom line
In the midst of a five-year bull market, it may be difficult for investors to remember that the global economy has still not recovered from the recession that shook the markets in 2008 and 2009. Unemployment remains high in many parts of the world, including the U.S. and Europe. As a result, Coca-Cola's poor performance may be excused by long-term investors, especially because it has performed better than its peers.

As the global economy emerges from the doldrums, Coca-Cola's results will inevitably improve. Until then, investors can count on similar quarterly results going forward.

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